Author: Jeremy Chia

One of the age-old questions in investing is how widely should we diversify. Unfortunately, it seems that even the best investors can’t seem to agree on this.

Legendary investor Charlie Munger is famous for being a supporter of a concentrated portfolio. He once said:

“The idea of excessive diversification is madness. Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.”

In 2017, Munger said that he owned just three positions in his personal portfolio – Berkshire Hathaway, Costco, and an investment in Li Lu’s investment partnership (which itself is highly concentrated).

At the opposite corner, we have other renowned investors who practised wide diversification and yet still achieved stunning results. For example, there’s Peter Lynch, who earned a 29.2% annualised return in his 13-year tenure managing the Fidelity Magellan Fund from 1977 to 1990. In his later years managing the fund, Lynch held as many as 1,400 stocks in the portfolio. 

Concentration and the risks

I recently had a short conversation with a friend on this topic of diversification. My friend is a proponent of having a concentrated portfolio, believing that we should not dilute our best investment ideas.

I agree that a concentrated portfolio may give you the best chance of higher returns. If you manage to build a sizeable position in a stock that becomes a multi-bagger (meaning a stock with a return of 100% or more), your return will obviously be better than if you had diluted your portfolio with other companies that ended up with lousier gains.

But we shouldn’t ignore the fact that having a concentrated portfolio can also magnify our losses. If your concentrated portfolio included a large position in a “big loser”, or perhaps in a fraud case such as Luckin Coffee, your portfolio-level return will very likely lag a more diversified portfolio.

Higher concentration = Higher variance

According to research by Alex Bryan from Morningstar, there is no real significance between a fund’s portfolio-concentration and performance.

What Bryan’s research did conclude was that more concentrated funds had a wider variance of returns. This means that concentrated funds had a higher chance of “blockbuster” returns but also had a higher risk of ending up with very poor performance. Bryan explains (emphases are mine):

“The risk in manager selection actually increases with portfolio concentration. So, while we didn’t find a link on average between performance and concentration, the dispersion of potential outcomes increases with portfolio concentration. So, really highly concentrated managers can miss the mark by a really, really wide range.

I think the other point to remember is that more highly concentrated portfolios tend to have greater exposure to firm-specific risk, and on average, that’s not well-compensated. So, again, you really want to keep an eye on risk and make sure that the manager that you hire is taking adequate steps to try to manage that risk that comes with concentration.”

How does this relate to the individual investor?

At the end of the day, how concentrated our portfolios should be depends on our risk appetite, skill, goals and ability to take on risk.

The more concentrated our portfolios, the greater the possibility of extreme returns – both on the upside and the downside. Are you willing to take on this risk and can you mitigate the risks with your ability to select stocks? These are some questions to ask yourself.

Ultimately, thinking about your needs, investment expertise, and circumstance will help you decide what level of concentration works best for you.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Costco.

Compounding is amazing, isn’t it? Just look at the graph below. It shows the nominal growth of the S&P 500, a prominent US stock market barometer, in the last 150 years.

What’s interesting about the chart is that the S&P 500’s growth accelerated over time. That’s exactly how compounding works. Nominal growth starts off slow but increases over time.

The chart below of the S&P500 over the last 150 years shows the same thing as above, but in logarithmic form. It gives a clearer picture of the percentage returns of the stock market over the same time frame.

The log-chart of the S&P 500 over the past 150 years is a fairly straight line up. What this tells us is that even though the return of US stocks have accelerated nominally, there was a fairly consistent growth in percentage terms over the time studied.

How do stocks compound?

This leads us to the next question. How?

In order to produce a 10% annual return for shareholders, a company that has a market value of $1 million needs to create $100,000 in shareholder value this year. The next year, in order to compound at the same rate, the company now needs to create $110,000 in shareholder value.

That figure grows exponentially and by year 30, the company now needs to create $1,586,309.30 to keep generating a 10% increase in shareholder value.

On paper, that seems outrageous and highly improbable. However, based on the historical returns of the stock market, we see that the S&P 500 has indeed managed to achieve this feat.

The reason is that companies can reinvest the capital they’ve earned. A larger invested capital base can result in larger profits. As long as they can keep reinvesting their earned capital at a similar rate of return, they can keep compounding shareholder value. 

But here’s the catch…

Although I’ve given an example of how a company can compound shareholder value over time, it really is not that simple.

Not all companies can create more shareholder value every year. In reality, corporations may find it hard to deploy their new capital at similar rates of return. Businesses that operate in highly competitive industries or are being disrupted may even face declining profits and are destroying shareholder value each year if they reinvest their capital into the business.

In fact, most of the returns from stock market indexes are due to just a handful of big winners. In 2014, JP Morgan released an interesting report on the distribution of stock returns. The report looked at the “lifetime” price returns of stocks versus the Russell 3000, an index of the biggest 3000 stocks in the US over a 35-year period.

What JP Morgan found was that from 1980 to 2014, the median stock underperformed the Russell 3000 by 54%. Two-thirds of all stocks underperformed the Russell 3000. The chart below shows the lifetime returns on individual stocks vs Russell 3000 from 1980 to 2014.

Moreover, on an absolute return basis and during the same time period, 40% of all stocks had a negative absolute return.

Even stocks within the S&P 500, a proxy for 500 of the largest and most successful US-listed companies, exhibited the same. There were over 320 S&P 500 deletions from 1980 to 2014 that were a consequence of stocks that failed, were removed due to substantial declines in market value, or were acquired after suffering a decline. The impressive growth you saw in the S&P 500 earlier was, hence, due to just a relatively small number of what JP Morgan terms “extreme winners”.

That’s why diversification is key

Based on JP Morgan’s 2014 report, if you picked just one random stock to invest in, you had a 66% chance to underperform the market and a 40% chance to have a negative return.

This is why diversification is key.

If historical returns are anything to go by, diversification is not just safer but also gives you a higher chance to gain exposure to “extreme winners.” Just a tiny exposure to these outperformers can make up for the relative underperformance in many other stocks.

Last words

Compounding is a game-changer when it works.

But the reality is that not all stocks compound in value over a long period of time. Many may actually destroy shareholder value over their lifetime. A useful quote from Warren Buffet comes to mind: “Time is the friend of the wonderful business, the enemy of the mediocre.”

Given the wide divergence of returns between winners and losers, we can’t take compounding for granted. By diversifying across a basket of stocks with a sound investment framework, or by buying a fund that tracks a broadly-diversified market index, we reduce our downside risk and increase our odds of earning positive returns.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

When we invest in a company’s shares, we are making a long-term bet that the share price will rise over time. But in investing, we never deal in absolutes but rather a range of probable outcomes.

This is where understanding the concept of a distribution of possible outcomes becomes useful. Using what we know now, we can build a simple distribution model of long-term returns. This will, in turn, guide us on whether a stock makes a good investment and if so, how much capital should we allocate to it. Here are some common distribution model graphs and how they impact our investing decisions.

Normal distribution

This is the most common probability distribution curve. Let’s assume that a stock is expected to double after 10 years. The distribution curve for a stock with a normal distribution of returns will look something like this:

In this scenario, the highest probability is for the stock to return 100%. There is also a chance that the stock can have lower or higher returns.

A narrower distribution of outcomes

There is also the possibility that a stock has a narrower distribution curve.

In this scenario, the variance of return for this stock is less. This means it is less likely to deviate from the expected 100% return over the time period.

We can say that this stock is less risky than the first one. Each stock may exhibit different degrees of the normal distribution curve. The thing to keep in mind here is that the taller the peak, the lower the variance and vice versa. So a very flat curve will mean the stock has a high variance of returns and is riskier. Bear in mind that these distribution curves are modelled based on our own analysis of the company.

Bimodal distribution

There are also stocks that have a bimodal distribution. This means that there are two peaks or two likely outcomes along with a range of other outcomes that cluster around the two peaks.

In the above example, the stock’s returns cluster around two peaks, -80% and +300%. The numbers are arbitrary and are just numbers I picked randomly. The point I am trying to make is that bimodal distribution can occur when there are two distinct possibilities that can either make or break a company.

A useful example is a biotech stock that requires FDA approval to commercialise its product. If it succeeds in getting FDA approval, the stock can skyrocket but if it is unable to get the regulatory green light, it may run out of money and the stock price can fall dramatically.

How to use probability distribution curves?

We can use a probability of outcomes distribution model to make investment decisions for our stock portfolio.

For instance, you may calculate that a stock such as Facebook Inc has a 10-year expected return of 200% and has a narrow normal probability curve. This means that the variance of returns is low and it is considered a less risky stock.

On the other side of the coin, you may think that a stock such as Zoom Video Communications can exhibit a normal distribution curve with a modal return over 10 years of 400%. But in Zoom’s case, you think it has a wider variance and a flatter distribution curve.

In these two scenarios, you think Zoom will give you better returns but it has a higher probability of falling short and a much fatter tail end risk.

With this mental model, you can decide on the allocation within your portfolio for these two stocks . It won’t be wise to put all your eggs into Zoom even though the expected return is higher due to the higher variance of returns. Given the higher variance, we need to size our Zoom position accordingly to reflect the bigger downside risk.

Similarly, if you want to have exposure in stocks with bi-modal distribution, we need to size our positions with a higher risk in mind. Some stocks that I believe have bimodal distribution curves include Moderna, Novocure, Guardant Health and other biotech firms that are developing novel technology but that have yet to achieve widespread commercialisation.

Portfolio allocation

As investors, we may be tempted to invest only in stocks with the highest expected returns (ER). This strategy would theoretically give us the best returns. But it is risky.

Even diversifying across a basket of such high variance stocks may lead to losses if you are unfortunate enough to have all these stocks end up below the ER you modelled for.

Personally, I prefer having a mix of both higher ER stocks and stocks that have slightly lower ER but lower variance profile. This gives the portfolio a nice balance of growth potential and stability.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Facebook Inc and Zoom Video Communications.

For non-software engineers like me, the topic of software can be extremely difficult to grasp. The mechanics and use case of a company’s software, where it is hosted, how the software is used or how it is different from the competition, can be complex. This is especially so for enterprise software that non-tech folks never have the chance to interact with.

Although I’ve read my fair share of IPO prospectuses and annual reports of software companies, many terms may still confuse me. But not investing in software companies because you don’t understand them can severely handicap your returns. Software companies today are highly prized due to their highly recurring revenue model, rapid growth, and expanding addressable markets.

As such, I occasionally turn to blogs and websites from experts who are able to explain the technicalities more clearly. Here are three such sites that I turn to understand software companies.

Site No.1

Software Stack Investing is a blog run and written by Peter Offringa. Peter has a rich history in the software space, leading software engineering teams for Internet-based companies for 20 years and serving as CTO at a number of companies.

His blog posts are long and highly technical but he tries to explain as much of it as simply as possible so that even the layperson can understand.

One of the highlights of his blog is his transparency. He states what stocks he bought and sold and he also incorporates his own personal views on companies and how he thinks they will perform five years out.

Peter does a thorough competitive analysis for every company he covers which gives the reader a better understanding of how one company’s software compares with another.

In his blog, he covers stocks such as Datadog, Alteryx, Fastly, Twilio, Cloudfare, MongoDB, Elastic, Okta and Docusign.

Most of these stocks offer enterprise software, which may be more technical than consumer software companies. As such, Offringa’s blog post helps fill a huge information gap for non-tech experts.

Site No.2

Stratechery is probably one of the more well-known blogs focused on technology and media businesses. It is run by Ben Thompson, who worked at Apple, Microsoft and Automattic.

His blog covers much more than pure-play software companies. But when he does cover software companies, he does a great job in breaking down what they do and how they match up to other software.

Some of his work requires a subscription. Nevertheless, the free content on his blog alone already provides great analysis and tools if you are looking for a place to read about tech and software companies.

Site No.3

The Investor’s Field Guide is a website run by Patrick O’Shaughnessy who is also the CEO of the asset management company, O’Shaughnessy Asset Management, that is founded by his father, Jim.

The website contains a collection of podcasts (and transcripts) on his interviews of some of the world’s top professionals in their respective fields. He has interviewed leaders of venture capital firms, CEOs of tech companies, psychologists and other business experts who provide deep insight into their area of expertise.

Naturally, software is one of the topics that he has covered. Some of the more recent podcasts on software include an interview with Eric Vishria, a partner at renowned venture capital firm Benchmark Capital, and joint interviews with Chetan Puttagunta, another partner at Benchmark Capital, and Jeremiah Lowin, the founder of Prefect, an open-source data engineering software company.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Datadog, Alteryx, Twilio, MongoDB, Okta and Docusign..

If the price of a company’s stock went up, it’s more expensive, right? Well, not exactly. Stocks are not something static. Stocks represent part-ownership of an actual and ever-changing company.

Because the underlying company changes, its value may go up or down. If a company’s share price rises slower than its intrinsic value, the stock may have actually gotten cheaper even after the price increase.

What determines intrinsic value?

Most investors agree that a company’s intrinsic value is determined by the company’s cash on hand and the future free cash flows that it can generate. This cash can be used to grow the company or returned to shareholders through buybacks or dividends.

Investors often use historical price-to-earnings and price-to-free cash flow ratios as a proxy to gauge how cheap or expensive a company is.

Facebook shares

Facebook is an example of a stock whose price has risen, but that has actually gotten cheaper based on its earnings and free cash flow multiples.

The chart below shows Facebook’s stock price against its price-to-earnings (P/E) and price-to-free cash flow (P/FCF) multiples over the last five years.

The blue line is Facebook’s stock price. In the last five years, Facebook’s stock price has climbed 220% from US$88.26 to US$282.73.

The red and orange lines show the social media giant’s P/E and P/FCF ratios over the years. As you can see, the P/E ratio has trended downwards, while the P/FCF flow ratio has remained largely flat. This is because the growth in Facebook’s earnings and free cash flow over the last five years has outran and kept pace, respectively, with the rise in the company’s share price. As such, based on these valuation multiples, Facebook shares can actually be considered cheaper today than they were five years ago, even though the price is higher.

Buying stocks with high valuations

The Facebook example highlights that buying a stock at a high P/E ratio may still reap good returns for investors.

In the past, Facebook shares traded at much higher P/E ratios than they do today. Yet buying shares then, still resulted in solid returns.

What this tells us is that if we buy into a quality company that can grow its free cash flow and earnings at a fast rate, even a compression in the stock’s valuation ratios will still lead to strong share price performance.

Final words

Investors often confuse stock price movements as a change in the relative cheapness of a company. If the price of a stock rises, we assume it has become more expensive and vice versa. However, that completely misses the bigger picture.

The difference between a company’s stock price and future intrinsic value is what makes a company cheaper or more expensive.

We should, therefore, put more emphasis assessing whether the company can grow its earnings and free cash flow and the longevity of their growth runway, rather than looking at the recent price movement of a stock.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Facebook.

Accounting scandals have been in the spotlight in recent months. Companies such as Wirecard and Luckin Coffee are two of the more recent high profile cases that have cost investors billions of dollars.

Worryingly, both companies were given a pass from reputable auditors before their respective cases blew up. As investors, we rely on external auditors to give us a sense of the company’s financial well being. But with the latest scandals, can we truly trust an auditor’s stamp of approval?

Nothing new

There have been many high profile accounting scandals over the past few decades. 

One major example that comes to mind is the accounting scandal of Waste Management Inc. In 1998, the company was revealed to have faked over US$1.7 billion in earnings from 1992 to 1997. Then CEO, A. Maurice Meyers was eventually found guilty along with other top executives and the SEC (Securities & Exchange Commission) fined Arthur Anderson, the company’s auditor, over US$7 million.

But the case that truly shocked the world came a few years later in 2001- Enron. Enron was a US energy, commodities, and services company. In that year, it was discovered that the company had been using accounting loopholes to hide billions of dollars of bad debt, while inflating earnings. Within a year, Enron lost US$74 billion in market capitalisation. Its auditor was again Arthur Anderson, which by then had lost so much of its reputation that it was forced to dissolve.

Recent scandals 

You would thought that the demise of Arthur Anderson would have brought a swift change to the industry. And yet, more than two decades later, we still hear of major scandals rocking the financial world.

Earlier this year, the China-based but US-listed coffee chain, Luckin Coffee, admitted that at least US$310 million of its sales over the previous three quarters were fabricated.

Today, Luckin Coffee’s shares have been delisted from the NASDAQ exchange where they were previously listed, and the company’s survival is in serious doubt. One of the company’s major shareholders is none other than GIC, one of the Singapore government’s investment arms, owned 5.37% of the Chinese company as recently as March 2020.

The other big-name scandal this year was Wirecard, a high flying payment solutions company that is headquartered and listed in Germany. It was considered one of Germany’s tech success stories and was briefly included in the country’s main stock market bellwether, the DAX index.

However, on 25 June this year, Wirecard filed for insolvency after revealing that €1.9 billion in cash was missing from its coffers. One of the company’s largest investors is Softbank, which injected €900  million cash in 2019. Softbank has since joined efforts with Wirecard’s other investors to pursue legal action against the company’s auditor, EY.

Worrying for investors

Although the vast majority of companies are free from accounting fraud and investors can fully trust whatever they see on the financial statements, these recent accounting scandals cast a shadow of doubt for investors.

Both Wirecard and Luckin Coffee were audited by reputable auditors and yet both managed to distort their financial statements. Even professional investors such as GIC and Softbank were badly burnt.

Most worryingly, Wirecard reportedly managed to hide the missing cash from auditors for years. As investors, we often look at the cash statement as the most reliable piece of information because cash is traditionally the hardest to manipulate. And yet, Wirecard was able to mislead investors that they had more than US$2 billion in cash, which they didn’t.

What other steps can we take

As investors, we usually look to the auditor’s report as the source of truth. They are supposed to be our neutral insiders. Yet, the past few scandals have shown that sometimes an auditor’s stamp of approval is simply not enough.

So what more can we as investors do?

I think as investors, it is difficult to sniff out whether a company’s financial statements are legitimate. Even big-name investors may end up betting on the wrong horse. The best we can do is to look at trends and market data. For instance, investors should look at the past track record of the company, the background of the managers, and where the company is audited and listed.

If anything seems amiss or too good to be true, our danger-radar should be up.

Portfolio sizing is also important to try to reduce the risk of accounting scandals. Having a sufficiently diversified portfolio and sizing down a position that you think has a greater risk of fraud ensures that if you are unfortunate enough to bet on a fraudulent company, your portfolio as a whole will still not be severely impacted. 

A call for change

Based on recent scandals, we can see the clear conflicts of interest for auditors. Auditing firms are paid by the company that they are auditing, and these contracts may be worth millions of dollars. 

To protect their nest egg, auditors could be under pressure to turn a blind eye on accounting malpractice, as was the case in the Enron scandal.

Changes, therefore, need to be made in the way companies are audited. The conflicts of interest create an unnecessary incentive and can be the reason why accounting fraud may take such a long time to be detected.

Regulatory bodies need to find a way to reduce these conflicts of interest to prevent accounting scandals that not only hurt investors but the integrity of the financial markets as a whole.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Many tech companies nowadays use stock-based compensation to reward managers and employees. Some even pay as much as 80% of executive pay in stocks or options. I’m personally a fan of stock-based compensation for a few reasons.

A fan

For one, stock-based compensation is not a cash expense. Cash is the lifeblood of a company and is vital for a fast-growing business.

Second, stock-based compensation aligns management’s interests with shareholders. Executives and employees become shareholders themselves who are incentivised to see the stock perform well.

In addition, companies may pay executives through stock options or restricted stock units that vest over a few years. With a multi-year vesting period, executives are incentivised to see the stock do well over a multi-year period, which aligns their interests with long-term shareholders.

All these being said, stock-based compensation does create a headache for analysts: It leads to a mismatch between the company’s profit/loss and its cash flow.

Stock-based compensation is recorded as an expense in the income statement but is not a cash expense. As such, companies who use stock-based compensation end up with higher cash flow than profits.

Why adjusted earnings is not good enough

To account for the difference, some companies may decide to provide adjusted earnings. This is a non-GAAP accounting method that adjusts earnings to add back the stock-based compensation and other selected expenses.

The adjusted earnings figure is closer to the company’s actual cash flow. But I don’t think this is the best method to measure the impact of stock-based compensation.

Adjusted earnings do not take into account the dilutive impact from stock-based compensation.

Free cash flow per share may be the best metric to use

So how do we best measure the impact of stock-based compensation? Amazon.com’s founder, Jeff Bezos once said,

“Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize.”

I completely agree. With the growing use of stock-based compensation, earnings per share is no longer the most important factor. Free cash flow per share has become the more important determinant of what drives long term shareholder value.

This takes into account both non-cash expenses and the dilutive impact of share-based compensation. By comparing a company’s free cash flow per share over a multi-year period, we are able to derive how much the company has grown its free cash flow on a per-share basis, which is ultimately what shareholders are interested in.

Ideally, we want to see free cash flow growing much faster than the number of shares outstanding. This would lead to a higher free cash flow per share.

Conclusion

To sum up, stock-based compensation is a good way to incentivise managers to act on the interests of shareholders.

However, it creates a challenge for analysts who need to analyse the performance of the company on a per-share basis.

In the past, earnings used to be the best measure of a company’s growth. But today, with the growing use of stock-based compensation, free cash flow per share is probably a more useful metric to measure a company’s per-share growth.

By measuring the year-on-year growth in free cash flow per share, we can derive the actual growth of a company for shareholders after accounting for dilution and any other non-cash expenses.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. We have a vested interest in Amazon.com shares.

Are stocks too expensive? On the surface, it certainly seems so.

The US economy declined by 32.9% on an annualised basis in the second quarter of 2020. Sequentially, it fell 9.5% from the first quarter, marking the fastest quarterly contraction on record. Worse still, many parts of the world are still in full or partial lockdowns and the travel industry is still effectively in a standstill.

And yet, the S&P 500 – the major US stock market benchmark – is roughly flat year-to-date. There is clearly a mismatch between the US stock index and the economy.

But if you think that the index is going to fall because of this mismatch, what are those invested missing? Are they all experiencing FOMO (fear of missing out) or are they all just plain dumb? I don’t have the answers, but I want to present some information as food for thought.

The key reasons

Based on my observation, there are two main reasons that market watchers point to for causing an expensive stock market. They are (1) Robinhood traders rushing to buy stocks and (2) the extra liquidity created by the Federal Reserve causing a rise in asset prices. Robinhood is a mobile app that provides commission-free trading for financial instruments such as stocks, exchange-traded funds, and more.

But Robinhood traders only make up a fraction of all market participants. There are market shorters, big hedge funds, and other professional investors that are participating in the market too. If stocks are too expensive because of exuberant demand from Robinhood traders, it is likely that there will be investors who will be shorting the market and keeping prices in check.

Second, the extra liquidity injected by the Federal Reserve is here to stay and is, therefore, rightly, an important determinant of stock prices.

Discerning

The fact of the matter is that everyone is seeing the same thing. Most of us are not special investors with special insights.

Yes, the stock market has reached bubble levels in the past but bubbles are rare. Most of the time, the stock market is fairly efficient. Could it be the case now?

If we take a closer look at the S&P 500, we can see a division in price performance between companies that are fundamentally sound and those that are not. For instance, technology stocks have made up the bulk of the market’s gains this year, while companies in sectors that have been hit the hardest have taken the brunt of the fall.

Year-to-date (as of 1 August 2020), the top-performing sector in the S&P 500 is Information Technology, which is up 21%. That’s backed by strong fundamentals. Many technology companies have seen a surge in revenue and profits in the most recent quarter. Amazon, Apple, Facebook and Netflix, for example, reported a year-on-year increase in revenue of 40%, 11%, 11%, and 25% respectively, for the second quarter of 2020.

At the other end of the spectrum, we have energy and financial stocks that are down 40% and 21% respectively as they are likely the hardest-hit from the current COVID-19-driven economic contraction. Airline stocks are also far below their pre-COVID-19 levels. Local flag carrier Singapore Airlines’ share price is down 62%, while the major US airlines are down between 40 and 70%.

All of which seems to indicate that market participants have been discerning about which stocks to sell down and which to price up.

The stock market and the economy

It can be easy to assume that the stock market and the economy are the same things. But there are actually big differences.

The S&P 500, a commonly used barometer to gauge the stock market in the US, only comprises around 500 companies. Within the index, the top five companies – Alphabet, Amazon, Apple, Facebook, and Microsoft – have a combined weight of around 22%.

A rise in the price of the top five companies can disproportionately impact the index. This is exactly what is happening. The big five, along with Netflix, have seen their share prices increase substantially this year. If we exclude the performances of just these six companies, the S&P 500 would be down substantially for the year so far.

Furthermore, being an index of just 500 companies, the S&P 500 does not take into account the rest of the 30 million-plus businesses in the US, many of which are SMBs (small, medium businesses). In fact, SMBs generate around 44% of the US’s economy activity, according to a recent study from The Office of Advocacy of the U.S. Small Business Administration. And unfortunately, SMBs are the most impacted businesses in the US during the COVID-19 pandemic.

Who knows?

Nobody knows how this will all play out. The ending’s not written yet. It is only with hindsight that we can tell if the stock market is currently making sense, or if it’s not.

But this is why investing is hard, and why beating the market is even harder.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Alphabet, Amazon, Apple, Facebook, Microsoft and Netflix.